Swaps, futures and forwards

1. Prepaid swap (commodity):
Prepay for commodity delivery in next few periods. Based upon forward / term structure of interest rates and the price of commodity from futures market

2. normal swap:
Fixed payments for the long position, the short position bears interest rate risk etc.

If interest rate change in between, calculate new values accordingly..

The net of swap is no longer zero once we proceed in time: one side could be +ve net at any time

3.
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Forwards:
Storage costs can produce contango...
Lease rate: the amount of money a lender requires to lend a commodity

Seasonal production vs constant production..

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convenience yield: will produce opposite effect of storage costs

5-3-2 commodity / crack spread

Strip hedge:

Short stack hedge:

Equities and asset allocation

Tracking an index:

Optimization strategy:
looks at factors to replicate, ensure correlations are minimized, quant heavy.
Uses LP or similar to construct target portfolio
Look for low cost way to ensure minimal tracking risk by targeting factors
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Active return = true active return + misfit return
(True active return = manager's return - manager's benchmark)
(Misfit return = manager's benchmark - investor's benchmark)

SD:
True active risk = the standard deviation of true active return
Misfit risk = the standard deviation of misfit active return

Mgr can use different stocks not inside a benchmark for his/her active portfolio benchmark as long as he keeps the misfit risk low (and tracks the benchmark well)

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Core - satellite portfolio: anchored mostly in index fund, use active mgmt for inefficiently priced assets:
can be thought of actively managed satellite portfolios surrounding the core


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Completeness fund: added to active portfolio to bring the risk back in line with the equity benchmark; brings misfit risk to almost zero.

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Managed futures:
Risk between bonds and equities; -ve or low correlation with equities; moderate correlation with bonds

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Venture capital:
Seed/early stage : before revenue
Later stage: after revenue starts coming in
Exit stage: selling the inv etc
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Preferred stock: typically later round preferreds are senior to earlier rounds
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Typical PE fund has life time of 7-10 yrs
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Commodity future return:
Spot return: Appreciation in spot price
Roll return: makes money in case of backwardation: the future price increases over time to match spot price
Collateral return: return on any asset held as collateral
[The collateral return or “collateral yield” is the result of the no-arbitrage assumption that if an investor is long a contract and invests an amount in T-bills that will be equal to the amount required to pay for the required purchase at the maturity of the futures contract. Such a fully-hedge position should earn the risk-free rate.
]
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commodity as hedges to inflation: commodities whose demand changes with economic climate (energy etc) are better hedges to inflation than otherwise as agricultural commodities.
Also storable commodity is a better hedge than non storable...

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hedge fund compensation:
AUM fee : 1 - 2%;
HWM (high water marks): to avoid double dipping; each high value of fund when incentive is paid is established as high water mark.

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FOF : suffers from less survivorship bias; but can have style drift
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hedge fund performance measurements:
Sharpe ratio not a good indicator because:
a) Upward bias for long time periods as extreme volatility is masked
b) Inappropriate for skewed, non normal distributions
c) illiquid market and infrequent trading the return observations could be wrong
d) Correlations not captured,

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Emerging market

Market liberalization vs market integration
are not same:
For example, a country might pass a law that seemingly drops all barriers to foreign participation in local capital markets. This is a liberalization, but it might not be an effective liberalization that results in market integration

Emerging market returns are *not* normally distributed

* Bid /as spreads could increase in the beginning of liberalization

Fixed income asset allocation

Cash flow matching vs multiple liability immunization:

cash flow matching involves investing in bonds that will provide cash inflows that exactly match the outflows required for the liability
whereas
in multiple liability immunization you are not necessarily trying to match all cash flows, you want the average duration of the portfolio to match the average duration of your liabilities and the present value of the assets to match the present value of the liabilities, while ensuring that the range of the asset durations are greater than that for the liabilities

Disadv:

Cash flow matching depends upon all the cash flows of the portfolio, so expectations regarding short term reinvestment rates are critical. For this reason, managers must use conservative reinvestment assumptions for all cash flows
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Combination matching: try to do cash matching in early years and duration matching in later years

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Portfolio rebalancing:
after change in duration and value of portfolio, bring
rebalancing ratio = (old dd/new dd) = (target asset value)/current asset value

Writing IPS

Return objective:
Keep focus on long term objective
Talk about: a) Any Short term needs
b) If the client's return is unrealistic, need to be educated of it
c) Overall shall reflect long term direction
e.g. Focus: growth vs income, also whether it is Long term capital growth focus vs short term safety

Risk:

- Compare client's willingness to ability (financial situation etc)
- Educate client if necessary of their real ability -> look at actions more than words
: write like average, below average and above average
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Constraints:

Liquidity: Talk about small emergency cash reserve whether stated explicitly or not
b) Regular cash need from portfolio
c) One time cash need

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Time horizon: pre retirement, following retirement ec

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Tax: loss carryforward etc, tax bracket...

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Legal etc

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Unique:
Specific to job, correlatons etc



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Insurance company IPS:

a) Surplus requirement: could threaten confidence in insurance company if not treated seriously
b) Ensure duration match between ALM, otherwise could have forced sale of assets at times
c) segmentation: group similar duration or interest rate sensitivity characteristics together: reduces regulatory concerns as well
d)Surplus portfolio focus: long term growth
e)

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Bank IPS:
Securities portfolio vs loan portfolio: the two balance each other in terms of duration, riskiness, liquidity etc to meet liabilities

fixed income strategies

1. Shortfall risk: the probability of not meeting required liabilities obligations...
(how to graph it ) ?

2. Credit spread forward: both parties agree on the rate in future, long pays fixed rate (as agreed today), short pays the spread rate in future.

Long benefits from increase in credit spread, short benefits from decrease.

payoff = (credit spread at maturity - credit spread now)* notional amount * risk fator

Managing funds against bond market index

Index matching strategies for funds:

1. Simple index tracking

2. Enhanced index tracking, low amount of change:
- yield curve positioning
- call exposure positioning : advantage of inefficiency in callbale bonds yields etc
- sector and quality positioning

3. active investment strategy
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Secondary trading of fixed income:

Reasons:

1. Yield / spread pickup trades: thought that more yield compensates more than needed for lower rating
2. Credit upside trade: expect a credit upgrade in future
3. Credit defense : in response to rating change
4. new issue swaps, sector rotation: new fixed income issues, sector changes, fixed to floating

5. Curve adjustment: in response to yield curve changes
6. Structure trades: in and out of puttable, callable and bullet bond structures dpeending upon interest rate moves.
7. Cash flow reinvestment: How much cashflow is coming from matured issues to absorb supply, and new money for new issues etc.

Spread analysis:
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a) Alternative spread measures: swap spreads , credit default swap spread:
CDS spread: the cost of annual insurance
swap spread: a way to compare between floating and fixed rate market
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Primary market:

Counter intuitively: more debt issuance in investment grade market validates and enhances old debt; compressing credit spread instead of increasing it.

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Liability immunization:
Multiple liability immunization:
sufficient liquid assets to meet all the liabilies that come in the way

cash flow matching: need to look at average reinvestment ratio; assume conservative reinvestment estimates, assume this is fully invested for the duration of horizon.

horizon matching strategy: combination of multiple liability immunization and cash flow matching.

Asset allocation (Reading 26)

Paper by BHB in 1986 (Brinson, Hood and Beebower):

Strong evidence thru regression that portfolio performance is 93% explained by asset allocation (the portfolio policy of % dedicated to stocks, sectors in stocks, bonds and cash); and maybe 7% by individual managers' skills.

Made asset allocation strategy a big deal compared to individual; not challenged seriously till 1997 (William Janke)

ALM (Asset / liability mangement): Explicitly model liabilities and find optimal asset allocation to meet those liabilities over the desired time period.
(Ensure matching)

Static vs dynamic: Dyanmic takes inter - period linkages into account whereas static is more like a single period allocation. However applying dynamic ALM could be quite expensive...

Risk objectives and strategic asset allocation:

Investor's expected utility Um =
E(Rm) - 0.005Ra *(sigma)2
(expected return - risk aversion * variance of the return for mix m)


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Safety first ratio
Utility adjusted return
Sharp ratio
Sortino ratio

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Black Litterman MVO: First have estimations of different asset types expected returns.
Add to those : the investor's expectations...and his confidence in his abilities.

Use the new expected returns in the MVO model to get the right asset weights.

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Resampled efficient frontier: values from multiple efficient frontiers.

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corner portfolio concepts in mv optimization...